WARREN BUFFETT: WHY GOLD IS A LOSING LONG-TERM BET….

Warren Buffett is out with a very good piece in Fortune that describes why he believes gold could be a bubble. This is a controversial call, but I think his broader message warrants a great deal of attention. Buffett breaks down investments into three categories. The first category is things that are currency based investments like bonds, mortgages, deposits, CDs. The second category is things that don’t produce anything, but require ever increasing hope that someone else will purchase the asset from you at a higher price. And the third category is things that are productive.

I’ve discussed this in the past in some detail. Commodities are nothing more than speculative bets. Gold is not unique in this way. When an investor seeks long-term capital appreciation they should always seek productive assets. In essence, you want to bet on the ingenuity of man. The French philosopher Volney wrote about this in his classic Empire of Ruins. He called man’s innate desire to improve “natural law”. He said:

“And what is the natural law?” replied the simple men. “If that law is sufficient, why has he given any other? If it is not sufficient, why did he make it imperfect?”

“His judgments are mysteries,” said the doctors, “and his justice is not like that of men.”

“If his justice,” replied the simple men, “is not like ours, by what rule are we to judge of it? And, moreover, why all these laws, and what is the object proposed by them?”

“To render you more happy,” replied a doctor, “by rendering you better and more virtuous. It is to teach man to enjoy his benefits, and not injure his fellows, that God has manifested himself by so many oracles and prodigies.”

Humans have this innate desire to improve, to innovate, to create, to build and to generally demand a better standard of living for ourselves. This is a powerful desire. So powerful that betting against it is practically a guaranteed losing bet. When you bet on an unproductive asset you are essentially betting against human innovation. In fact, you are essentially betting that living standards will generally stagnate or decline.

Buffett puts the current gold outlook into perspective with an excellent analogy:

“Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce — gold’s price as I write this — its value would be about $9.6 trillion. Call this cube pile A.

Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?

Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers — whether jewelry and industrial users, frightened individuals, or speculators — must continually absorb this additional supply to merely maintain an equilibrium at present prices.

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops — and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil (XOM) will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.”

Now, as a hedging device, the first two categories can function as excellent buffers. Capital appreciation, innovation and increasing living standards are no guarantee in the short-term. And the last 10 years have certainly proven this to be accurate. But over the very long-term the trend in improving living standards due to ingenuity is a trend you cannot fight and should not fight. After all, it is not the pile of rocks that produces great things, but the man/woman who uses the pile of rocks to build something, that does great things.

This all feeds into my work on Monetary Realism, understanding our monetary system and understanding the world we should seek to leave for our children. After all, we do not leave our children this mythical burden of debt that so many pundits constantly discuss. Rather, we leave them a certain living standard. And as a society, we should not seek to invest in rocks or promote activity that is unproductive. We should seek to give our ancestors the ultimate gift – the gift of time through innovation and maximizing human ingenuity. This is the true path to prosperity. And while investments in unproductive assets might benefit man in the short-term, over the long-term the desire to innovate, be better and be more virtuous will always prove a more fruitful investment.

* Mr. Roche maintains a small position in gold and invests the majority of his long-term portfolio holdings in bets on human ingenuity.